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May 2, 2001

Holding the Bag

Stock options enriched some clients, but left othe

It's a cheap shot to find fault in hindsight. But let's do it anyway. In the past decade so many people made so much money--through tech stocks, company options, IPOs, and blind luck--that many wanted to make even more. As Barbara Steinmetz, a Burlingame, California, advisor and accountant, puts it, "Why would anyone sell and take profits at 300 or 400 times the original value when the stock was going to the moon?" Chalk it up to tough times, bad luck, or the reality of rational exuberance, but while some investors have become richer, others have been losing their shirts. And according to Steinmetz, the nightmare is just beginning.

"You ain't seen nothing yet. We're seeing some real ugliness, and it's starting with a vengeance," she says, referring to accountants informing more than one of their charges that what he or she owes in taxes exceeds their entire net worth.

The culprit? Employee stock options. Take the case of Susan Secretary (fake name, real occupation). Susan worked at a high-tech firm in Texas, pulling in around $40,000 a year. The stock in the options Susan's company gave her and other employees appreciated 1,000% and split three times. Not long ago, on paper, at the time she exercised and held, she was worth about $5 million. Not long after--Susan had exercised and held--when the stock tanked, she was worth about $250,000, and her new advisor, Austin Asset Management in Austin, Texas, busied themselves "scrounging around trying to get her taxes paid," according to the firm's CFO Eric Hehman. The woman has been forced to liquidate most of her assets, since she refuses to sell her stock, believing it will shoot back up where it belongs.

Then there's the man in his early twenties involved in a start-up firm who exercised $1 million in options in company stock (his options were worth seven times that) with the intention of giving the million to a relative. The man assumed he would have plenty to spare. The relative was so thrilled that she immediately bought the very same stock. The stock dove deep. "About a month ago," relates advisor Tom McFarland, president of The Darrow Company, with offices in Boston and Los Angeles, "the man called us and said, 'I have a big tax bill, about $400,000. What am I going to do?'"

The Problem

What went wrong for these people? And what can be done to prevent similar scenarios from becoming those of your clients, while making you look like the rocket scientist that many of them actually are? To borrow from the lexicon of bumper stickers, Options Happen. They're complex, misunderstood, and often poorly handled. The option owners themselves are easy targets for blame--all 12-plus million of them. An Oppenheimer Funds study conducted last year noted that 37% of option owners surveyed claimed they knew more about Einstein's theory of relativity than they did about the tax implications of their options. The study also showed that 34% admitted they did not know what type of option they owned, while 29% were clueless as to what percentage of their options were vested.

Companies are at fault for not fully explaining the risks involved. "We have clients who've shown us a little handout from their company with grant paperwork and brief information on how it all works, but they didn't know what any of it meant," says Hehman. To their credit, however, an increasing number of companies has taken advantage of a Financial Accounting Standards Board loophole enabling them to utilize delayed repricings to salvage employees' battered options. What happens is that the company will, in effect, cancel employee options, and after six months, issue new ones at a lower price. The downside of repricing is said to lie in diminished shareholder value.

Options for All

Following are some salient facts about the breadth of employee stock ownership and options holdings in the U.S.

o Employees own, or have options to own, stock worth almost $800 billion, or about 9% of all the stock in the U.S.

o There are more than 10,000 Employee Stock Ownership Plans in the U.S., covering almost nine million participants and controlling over $210 billion in company stock.

o Of these ESOPs, about 15% are in publicly traded companies and 85% in closely held companies.

o The median percentage ownership for ESOPs in public companies is about 10%-15%. The median percentage ownership for private companies is about 30%-40%, with about 2,500 companies now majority employee-owned.

o While the typical firm has 20 to 500 employees, employees own a majority of the stock of such companies as Amsted Industries, United Airlines, Publix Supermarkets, and Science Applications, a 30,000-employee R&D firm.

o About half the ESOPs in private companies are used to buy out an owner; the rest are typically used as a primary employee benefit plan, sometimes in conjunction with borrowing money for capital acquisition.

o A growing number of companies are providing stock options to most or all employees. PepsiCo, Starbucks, and DuPont are among the better known examples. At least 200 large public companies now do this, as well as perhaps thousands of private companies (no precise estimates are available).

Source: Corey Rosen, executive director of the National Center for Employee Ownership

Financial advisors are not immune to blame, either, especially those not up to speed on the tax consequences of exercising options. Hehman maintains that less ethical advisors will go so far as to instruct a client to exercise in order to sell him "a bunch of mutual funds," neglecting to note that the client might owe Uncle Sam. Underscoring the complexity of stock options, says Steinmetz, is that in many cases advisors "don't understand them well enough to be doing it." As a financial advisor who also wears the hat of an EA (Enrolled Agent), an accountant licensed by the Department of the Treasury to practice before the IRS, Steinmetz believes that the planning profession has missed the boat somewhat by not placing enough emphasis on the importance of understanding the tax implications of planning actions not only with options, but in other areas as well.

Options Explained

Let's take a quick look at the anatomy of company stock options, which for a company employee are an opportunity not an obligation. There are two types, nonqualified and qualified. The former, also the most common, doesn't warrant any special tax considerations; it is treated like compensation or ordinary income, and taxed when exercised. If a company gives an employee an option at $10 (called the grant price, or the exercise or strike price) and the stock is worth $20, when the employee exercises the option (buys the stock) he will pay taxes on ordinary income on the difference.

It's hard to get in serious trouble with nonqualifieds (NSOs). What can happen, though, is this: When an employee (for example, in the 31.0% tax bracket) exercises, the employer will withhold at that amount, even though the profit may bump the employee up to the 39.6% bracket, that will require an additional 8% in cash for taxes, an amount the unwary employee may not have saved. Given the huge sums of money involved with many of these options, it could mean the difference of having or not having liquid an extra $100,000. It's not unusual in this instance, and especially with qualified options, for an employee to be forced to exercise more options in order to obtain more stock to sell to pay the taxes he owed from the options he already exercised. To safeguard against this, and make sure a client has "cash on the sidelines," Steinmetz will often have him instruct his company to withhold from his paycheck at a higher tax bracket, or pay estimated taxes.

Qualified stock options, also known as Incentive Stock Options (ISOs), are another story. With these, add to NSOs the elements of benefit and risk, since the option owner, usually a company executive, can exercise to sell, or exercise and hold. In either case, no taxes are paid until the stock is sold. With an NSO, the employee could exercise at, say, $10, sell that stock the same day at $20 and pay short-term capital gains on the difference. An ISO, however, lets him act on his desire for and expectation of an even greater profit, confident the stock will soar far beyond the grant price. With an ISO the executive can exercise an option and hold it for either two years from the grant date of the option or one year plus one day from its exercise, whichever is later, explains Carol E. Curtis in her recently released book "Pay Me In Stock Options: Manage the Options You Have, Win the Options You Want" (published in hardback by John Wiley & Sons, Inc. and retailing for $29.95). The idea is to sell the stock and enjoy huge profits along with the tax advantages inherent in long-term capital gains.

Rags to Riches

Here's an example of how an advisor can make the difference between an option holder reaching a goal and financial ruin. Mr. X, as we'll call him, wished to secure early retirement. Mr. Y, a co-worker, was hell-bent on becoming filthy rich. Curt Weil of Weil Capital Management in Palo Alto, California, relates how he sat down with Mr. X and an accountant using BNA tax-computation software. They ran the gamut of option-exercising scenarios to see what the outcomes would be in terms of taxes. Meanwhile, Mr. Y proceeded on his own.

Weil found that if Mr. X exercised his options and held onto his stock, he would face an alternative minimum tax bill of about $1.5 million. By utilizing a disqualifying disposition--exercising some of the options and selling the stock--he would reduce his AMT somewhat but be left with a fairly hefty tax bill. At the end, Weil recommended exercising and selling at least enough stock to turn into cash an amount equal to his client's worst tax bill.

"Bear in mind the cost basis on the stock--the option grants--were very low," explains Weil. "So at almost any price he was profitable. We put the money in the bank to pay his taxes, and bought a bunch of ultra-short-term municipal bonds and we sat there." His client's stock topped out at about $56 last July, dropping to a recent low of $8.50. Weil notes that Mr. Y, his client's buddy at work, given the identical grants, had exercised and held his stock in hopes of scoring a long-term gain.

While Weil's client is now on his way to early retirement, his buddy's tax bill is greater than his entire net worth. About the only thing the friend can do is hire a good tax attorney, go the Internal Revenue Service, and request a payment schedule, says Weil. He will have to pay a penalty for not having paid all his taxes and the interest on the unpaid liability. "The Service is pretty decent when you're up front and say you've got a problem," says Weil. "The worst thing you can do is play games with them or try to dodge them." The problem with the AMT hasn't escaped notice by the IRS. It may propose creating a hybrid option with the attributes of both an ISO and an NSO to lessen some option-holders' tax burden.--Cort Smith

Hehman explains these long-term capital gains benefits thusly: If you exercise that $10 option and pay on it the alternative minimum tax (26% on the first $175,000 of income, 28% above that; more on AMTs below), when you go to sell that stock you get a credit for that AMT. The AMT, explains Curtis, is a tax the IRS uses "to get you to pay some of the taxes it would have received if you did not get tax-favored options;" it was implemented by the government back in the 1980s to nail those then wealthy few in the $200,000 a year bracket. Thus, any gains are taxed at 20% versus the executive's ordinary income number, which could be as high as 39.6%. The company employee could do the same thing with a nonqualified option, Hehman adds, the difference being the employee would be taxed at the outset.

Hold or Fold?

Is it worth holding on to ISOs? Hehman doesn't think so. "It's a risky thing,' he says. "We don't do it for clients." Here's a good reason why. With long-term capital gains, the resulting tax credit is realized only when the employee pays the AMT. It's a problem because too many employees, and often their advisors, don't know an AMT from an ATM machine. In fact, the Oppenheimer study last year notes that 75% of those surveyed are not familiar at all with the alternative minimum tax. "There's folks who exercised options and didn't sell because their advisor said it'd be better to go for long-term capital gains," says Hehman. "But the advisor didn't tell them to keep money for AMT, and they're stuck with a tax bill they can't even afford." Advisor Steinmetz endeavors to avoid AMT shock by sending clients she knows have exercised a note warning them they could be subject to a special tax; the same information appears in a quarterly newsletter she sends to all her clients. "If that's the case," she tells them regarding the AMT, "let's talk about doing something about it."

To complicate things further, there is the matter of disqualifying dispositions. We've said that if an option is exercised and sold the same day as a short-term gain, no AMT is due. The same applies with an ISO if an employee buys mid-year and sells before December 31 of that same year, or if he leaves his company before the qualifying period is over, which Curtis notes is the latter of two years after the grant or one year after the exercise. In the event of a disqualifying disposition, an ISO will become an NSO, and be taxed as ordinary personal income. The AMT will be partially or fully reduced, leaving what could be, but does not have to be, a fairly hefty tax bill. Of course, as Steinmetz says, using a disqualifying disposition as a strategy can be advantageous.

The Solutions

Of late, the option woes of some employees faced with astronomical AMTs due April 15 have been exacerbated by their being suddenly unemployed by the company whose plummeting stock got them in hot water to begin with. If the bad news is the startling number of Americans in options hell, the good news is that their troubles spell tremendous opportunities for competent advisors and planners. In its 2000 study, Oppenheimer noted that only 36% of all option owners actually sought the advice of a financial professional; of those who exercised their options, more than half received no professional advice, with 21% consulting with friends, family and co-workers.

"Now, the people who thought they could do it all for themselves are finding out that maybe, just maybe, they need help," Steinmetz says. Advisors are in demand not only for their technical and planning expertise, but for their understanding and compassion. Planner Cort Cheney of Cheney Investment Group, Lafayette, Indiana, has a client who recently lost some $300,000 in stock-option value when his dot-com company collapsed. The client has two friends at the same company who are suicidal over their losses. "I think there's a chance of seeing some of that (suicides) in the national news if the market goes down much further," says Cheney.

Before you can right new clients' previous wrongs and set them on the path to prosperity, you need to know their mindset; what they are thinking about company stock options in particular and financial and life-matters in general. Hehman puts options in perspective, saying that "until you exercise the options and sell the stock, you're just earning a salary; you're just like everyone else."

Help on the Web

Here's where to go for additional information and tools on stock options.

Brainchild of Bend, Oregon-based Net Worth Strategies, offering financial planning software and services solutions. Products range in price from $695 for a single-user package to a five-user version at $2,595. Also serves as a resource and education center, with training seminars nationwide.

Options can be seen as corporate bait to lure potential employees into their fold. Options enable companies, especially start-ups, to pay workers an average salary while implying that the $10,000, or whatever dollar worth of options companies doll out, or make available through employee stock purchase plans, will have employees lined up to buy yachts in no time flat. Employees often give little thought as to whether or not their company will ever be profitable, or where they, themselves, will be in five years. Hubris and greed prevent many of them from realizing that more often than not, they just happened to take the right job at the right place at the right time; instead they equate the tripling of their company's stock with their personal work performance.

Peer pressure and the "cocktail party mentality" play a role in employee attitudes towards options; both are counter-productive attitudes that an advisor needs to readjust. Employees fear they will no longer be viewed as team players if they don't hold onto their options. At the same time, corporate culture bolsters the belief that employees who do hold, will not miss out on the party when their stock quintuples. As Hehman says, however, it's important for option-owning clients to see options for what they really are: compensation, as opposed to investment. "If you don't exercise your options, you don't have any money; you're not wealthy yet," he says. "No one was advising these folks to exercise, and many waited too long." The cocktail party mentality has everyone talking about stock X, and that if you don't own X, you're out to lunch; of course, no one knows what they're talking about. Or, there's the now's-the-time-to-exercise syndrome, says Steinmetz, when "all of a sudden you've got a rash of people running in panic mode because so and so's advisor said to exercise."

One of the most formidable client-attitude obstacles to overcome, and one that Steinmetz is afraid will "backlash" on a lot of people, is the comfort level many have attained with selling some of their stock in late March or early April to pay the tax liability on what they sold the previous year. Worse still, they believe fully in their stock's ever-increasing value to enable them to sell even more stock to pay the tax liability for the current year. "Now that's robbing Peter to pay Paul, and unfortunately Peter's out of money," says Steinmetz. "In some cases the stock they have left on the table isn't going to be enough to meet the liability. This concept hasn't hit a lot of them yet."

A Better Way

Yes, there are better ways. Hehman encourages most clients to simply exercise whatever options are vested, and if they're in the money, sell the stock. "Then we'll diversify and find some other interesting asset classes that will benefit if the market goes up anyway, versus leaving everything in one basket." For the client who has become accustomed to a standard of living that is "fluid upward and rigid downward," he uses this approach: "One of the first questions we ask is, 'Is there an amount of money that can support you for the rest of your life?'" Once the figure is established, and if it's readily available through exercising and selling options, Hehman will take the amount off the table and invest it in bonds. "Whatever else is out there, whatever happens to the other options that are going to vest over the next two to four years, won't matter." Implementing the plan is not always an easy sell, however. He's had potential clients walk through his door who didn't become clients because they refused to sell their options. He had another client so concerned with setting up a private foundation, with what would be his fortune, that he neglected to exercise his options. Forget the foundation.

Earlier we detailed the plight of the start-up-firm employee who exercised (and held) $1 million in company stock options, with the intent of giving away this $1 million to a relative. Unfortunately, since the stock had plummeted, the money was nonexistent. In short order he was out $1 million plus an extra $400,000 owed in taxes. The man had a major accounting firm advising him on the tax consequences of exercising ISOs, and a broker who sold some of the stocks for him. No one, however, coordinated these efforts. His back to the wall, the man went to see Tom McFarland. "He's not a client, he's a horror story," says the would-be advisor. "If only the man had exercised his options and sold; or if he wanted to give away the money, at least give away his part of the money, not his part and the government's as well."

Had the man been a client and still insistent upon giving his relative the $1 million, McFarland says "we would have to take the $400,000, buy a T-bill and mature it until March 31. Then the client could give away the $600,000 if he wanted to do that, because he's going to have estate and gift taxes; but at least he would have had the $400,000 in real money to pay the tax bill."

Like advisor Curt Weil (see sidebar "Rags to Riches") McFarland prepared his clients early for expectations relating to option shock and the bear market. "We'd ask clients, 'If you had the money, would you shell out a million and buy that stock?' They'd say no. We'd ask, 'Well, how big a check would you write? A $100,000? That means you should be diversifying 90% of your position.' It doesn't hit home until you do that." He also performs Monte Carlo simulations to show clients that their $1 million in options could be worth $9 million or $10 million if they hang on, or less than $100,000. "They begin to think a little out of the box."

Despite the number of persons who have or will be burned by options, there exist today some serious opportunities for those who have not yet exercised; there's still much money to be made, just not as much as before. Steinmetz says that when she performs calculations on options exercises she tries to figure out how much can be exercised in a given year to keep the client below "alt-min," or the AMT. A strategy that helps make this possible--especially advantageous at a time when stock prices are so depressed--is the use of the disqualifying disposition, mentioned earlier in this article. In her book, Curtis defines a disqualifying disposition simply as "an event" that results in an ISO being treated like an NSO. Such an event might be selling the stock before meeting the required holding period-exactly the strategy Steinmetz has in mind.

Sell early and beef up ordinary income, she advises, because the higher an option-owner's ordinary income, the more he or she has room to go into exercising the options that could incur AMT. "There is a level you can run right underneath and still exercise stock options and not have it be an issue," she says.

Joan Collins, of all people, once said: "Show me a person who has never made a mistake and I'll show you somebody who has never achieved much." There's a lot to be said for learning from past mistakes, though the hardest step is often first admitting that you've made them. Many option owners are like that; so are a lot of clients, and probably many of the rest of us. The doldrums of a down market is a good time to take stock, figuratively, and perhaps sooner than later, quite literally. It's also a great time to reexamine investment and planning basics, ignored too often in the market frenzy of the Roaring Nineties. The value of such an exercise is well expressed by advisor McFarland, who recalls that one of the best lessons he ever had occurred after the crash of 1987. "My client phoned and said to me, 'Remember the conversation we had about long-term investments?' I said, I remember that. And my client said, 'Well I do too.'"